ECB Preview: Draghi Turns Softer as Recovery Fails
- We expect the Governing Council to discuss rate cuts and at the press conference we believe Mario Draghi is likely to open the door for a rate cut in the coming months.
- However, we anticipate that euro area data will improve in the coming months, in which case the ECB is unlikely to actually deliver a rate cut.
- If euro area data does not show signs of improvement outside Germany in the coming months, we expect the ECB to deliver a 25bp refi rate cut in April or May.
- We think that a refi rate cut is the preferred option. A refi rate cut would make it more attractive for banks to keep liquidity and should lover rates in the two-year segment.
- Cutting the deposit rate to negative territory is also a possibility but we think it would come with more costs and less benefits.
- The ECB's staff projections are likely to remain almost unchanged. The inflation outlook might be revised down slightly, which gives the ECB further room for rate cuts.
- In the Q&A, Draghi is likely to be asked about Italy. We expect him to confirm that the ECB remains ready to do 'whatever it takes' but that politicians must first make sure that the conditions for bond purchases under the OMT programme are fulfilled.
Rate cuts are back on the table
We expect the Governing Council to discuss rate cuts as the projected euro area recovery has materialised only in Germany, while the rest of the euro area seems to remain in recession. German PMI has improved significantly since it bottomed in August 2012, while it has declined in France and remains low in recessionary territory in other euro area countries. Other euro area indicators remain soft as well. Bank lending remains weak, credit tightening continues and consumer confidence has improved only slightly from low levels. Car sales in the euro area have fallen to the lowest level in the 25 years on record. In addition, political uncertainty has increased since the Italian elections.
We do not expect the ECB to deliver a rate cut at this meeting for three reasons. (1) There are no early warnings in the communication from the ECB. The Governing Council discussed rate cuts in December but at the January press conferences Mario Draghi gave the impression that rate cuts were off the table and in February he said that the decision to keep rates unchanged was unanimous. (2) EUR/USD has weakened from 1.36 to 1.30 in only a month, which in itself contributes to lifting growth 0.3pp in the first year after the appreciation. (3) A surprise rate cut now could be misinterpreted as a reaction to the Italian election outcome.
We expect data to improve in coming months, in which case we believe the ECB will not cut rates. However, if euro area data does not show signs of improvement outside Germany, we expect the ECB to deliver a 25bp refi rate cut in April or May.
Refi or deposit rate cut?
A refinancing rate cut would make it cheaper for banks to keep the liquidity they have borrowed on the three-year LTROs. A refi rate cut should thus help to keep excess liquidity high, which would help to keep rates down. At the same time, a refi rate cut lowers the ceiling for EONIA rates, which should then rise towards 50bp rather than 75bp as excess liquidity goes down.
A deposit rate cut would bring the ECB interest rates into negative territory for the first time ever. It seems unlikely that banks would pass negative rates on to clients and banks would then have to keep lending rates for clients unchanged as well or accept a narrower margin. Negative rates could also turn out to result in unforeseen IT and administrative costs, although the ECB and banks have tried to prepare for this.
A deposit rate cut with the refi rate kept unchanged would widen the corridor and reduce banks' incentives to keep excess liquidity. This policy move would thus be likely to result in a quicker repayment of three-year LTRO money than would otherwise be expected, which would push rates upward. Even with an unchanged corridor, it is plausible that banks would be less willing to use the ECB deposit facility at negative rates and would choose to repay more than they would if the deposit rate remained at zero. In the case of a pronounced reduction in excess liquidity, a deposit rate cut could thus result in higher rates.
All in all, we think there are convincing arguments for lowering the refi rate but they are less so for lowering the deposit rate to negative territory. An argument against only lowering the refi rate is that if the corridor is narrowed, it would reduce incentives to use the interbank market instead of the ECB. Thus, we do not fully rule out the possibility that the ECB could choose to lower both policy rates in tandem and thus keep the corridor unchanged.
ECB staff projections
In December, the Eurosystem staff projected GDP will contract 0.3% in 2013 and grow 1.2% in 2014. This seemed too downbeat at the time but in the three months that have passed the recovery has been more sluggish than expected and in addition GDP growth in Q4 12 disappointed, resulting in a more negative carry over. In our view, if ECB staff revised the growth forecast for 2013 up it would be by 0.1-0.2pp at most but they probably will not increase it at all.
The ESCB midpoint forecast for inflation in December was 1.6% for 2013 and 1.4% for 2014. Inflation came down to 1.8% in February and core inflation came down to 1.3% in January. According to our calculations, this is in line with inflation at 1.7% in 2013. Thus, we might see a small downward adjustment to the ESCB staff inflation forecast.
It is clear that inflation is no hindrance to the ECB easing further. The question is whether inflation is now so low that it is in itself a reason for the ECB to cut rates. We think not. Influential members of the Governing Council are more concerned about the risk of elevated inflation caused by too loose monetary policy than the risk of deflation.
OMT for Italy
In the Q&A session, we expect Draghi to be asked about how the ECB will act if Italy suddenly needs help. We are sure Draghi will have prepared for this question and believe he is likely to reply that the ECB's OMT programme remains in place for Italy as well as for other countries and that the ECB stands ready to implement it if needed. However, he is then likely to emphasise that the use of the programme is conditional on the country in need complying with an ESM macroeconomic adjustment programme or a precautionary programme. On the one hand there is nothing new in this answer, on the other it is hardly comforting for observers conserved about the messy political situation in Italy.
The European money market curve has continued to flatten on market speculation that the ECB will cut the refi rate in coming months. The EONIA forward curve is roughly flat through 2013. We do not expect a cut in the deposit rate and we therefore believe the downside for EONIAs up to one year is limited. In the scenario where the ECB signals a refi cut, this will mainly affect EONIAs above 1Y and EURIBORs as a refi cut will effectively cap the upside risks to short-end rates when the 3Y LTROs expire in February 2015. If Draghi says that rate cuts were not discussed, we would expect some reversal of the latest move down in rates.
We intend to elaborate further on the market reaction in an interest rate strategy paper due to be published tomorrow.